Intergenerational wealth transfers create opportunities and risks, especially for those inheriting a large sum of money. And with boomer heirs on the precipice of the largest wealth transfer in history — an estimated $30 trillion over the next few decades — understanding the finer points of an inherited IRA is more important than ever.
Because it is someone else’s retirement plan, an inherited IRA can come across as almost alien to those on the receiving end, and recipients often have many questions: What options do I have for taking distributions? What are the tax implications? How do I incorporate this inheritance into my existing financial plan?
To make understanding the options a little simpler, below are some guidelines to consider when incorporating an inherited IRA into your financial plan. As you’ll see, it helps to distinguish between an IRA you inherit from your spouse and an IRA you inherit from a parent, sibling or someone else (where you’re determined to be a non-spouse inheritor).
Inheriting a Traditional IRA From Your Spouse
You can roll over this inherited IRA into an IRA you already have and the earnings will continue growing tax-deferred. You’ll pay income taxes on any distributions you take but, if you’re over age 59 ½, you won’t owe the 10 percent tax penalty for early withdrawals.
Rolling over an inherited IRA can be appealing, since you will gain control over the distributions. You just need to be sure the amount you withdraw is above the annual Required Minimum Distribution (RMD), the minimum amount you must withdraw from your IRA account each year once you have reached 70 ½.
It’s important to realize that taking inherited IRA distributions — especially a lump sum distribution — may bump you into a higher tax bracket, since the money will be counted as earned income for the year. Depending on your age, financial situation and immediate needs, however, a lump sum distribution can still make sense, since it will let you access the entire benefit right away. There is no 10 percent early withdrawal penalty for a lump sum distribution, but it will incur income taxes.
If you prefer to forego an immediate payout in favor of investing the inherited IRA, identify your investment goals and then incorporate your IRA allocation into your overall financial plan.
Inheriting a Traditional IRA From a Parent or Sibling
Here, too, you’ll pay income taxes on distributions from the inherited traditional IRA. You can’t, however, roll the inherited IRA into an existing IRA and you must begin withdrawing assets no later than December 31 of the year after the account holder passed away.
These distributions will be considered part of your annual income, and could bump you into a higher tax bracket. Conversely, if you don’t take the necessary distributions, you will incur a 50 percent tax penalty on the amount taken out below the RMD.
Inherited IRA Distribution Rules
Beneficiaries of inherited IRAs can choose to take distributions as an RMD over the course of their lifetime (what’s known as the life expectancy method), over a five-year period or as a lump sum.
The life expectancy option means a RMD will be set each year by the IRS, which must be made each year to avoid paying the 50 percent penalty on the amount taken below the RMD.
The five-year option gives you the ability to withdraw the funds throughout the five years, there are no RMDs and there is no early withdrawal penalty. After five years, any remaining funds in the account will need to be withdrawn.
The lump sum distribution results in a full payout of the account, paid out immediately after inheriting an IRA. You won’t incur a 10 percent early withdrawal penalty, but you will owe income taxes.
For most situations, the life expectancy option will be the most beneficial distribution method, since the funds remaining in the IRA will provide a lifetime of tax-free growth, prior to distribution.
The Rules for Inherited Roth IRAs
A Roth IRA is a retirement account funded with post-tax income that lets the account owner take distributions without paying income tax. When you inherit a Roth IRA, you also won’t pay income tax on your distributions, nor will the distributions count as taxable income when determining your tax bracket.
However, if you elect to take the life expectancy method, distributions that fall below the RMD will still be subject to the 50 percent penalty.
Mistakes People Make With Inherited IRAs
People typically make two mistakes when inheriting IRAs: They either forget to take the RMDs, or, with traditional IRAs, they take a lump sum distribution in a high-income year.
The first mistake results in a 50 percent penalty on the amount taken below the RMD. The second may cause the entire distribution amount to be taxed at a higher rate than necessary.
For individuals inheriting an IRA, understanding your options as well as the requirements and potential liabilities of those options is essential to making an informed election and to maximizing your potential benefits.
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